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“Oil Can, Oil Can” – The Tin Man’s Oil Crisis in “The Wizard of Oz”

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November 2004

One thing that you can count on with a commodity such as oil is that mild disruptions to its supply can cause giant short-term swings in its price. It amazes us that only a few years ago, we cited $10.00 oil in a newsletter only to see it trade at around $50.00 a barrel now. In this newsletter, we will review the current investment environment in the face of uncertainties surrounding oil, and reinforce our long-term bullishness for global growth.

First, a few observations. In our August, 1998 newsletter, we mentioned that “we are fresh out of dinosaurs” and that oil was, by definition, a finite resource. In a perfect economic system, every new barrel of oil should be priced higher than the last as we become incrementally closer to the end of its supply. In practice, there are tremendous differences in the estimates for global oil and gas reserves and wide variations in day-to-day supply. No fewer than six factors have influenced supply recently. These include hurricanes in the Gulf of Mexico, Iraqi issues, Libya expanding its oil program, Russia restructuring its oil companies and Nigeria and Norway with on-again, off-again strikes. Meanwhile, global demand is increasing due to economic growth, especially in China.

Despite long standing oil supply problems, the average mile per gallon of the typical American automobile has steadily dropped. During the nineties, it fell to its lowest level in decades. Moreover, our country has been filling our emergency strategic reserve. Shamefully, America consumes 40% of the world’s gasoline, but we comprise just 5% of the globe’s population. The flip side to that embarrassing fact is that a relatively minor change in our behavior will drastically impact global supply. For example, if the average mile per gallon consumed by the American car rises steadily from 20 mpg now to 30 mpg over the next automotive purchasing cycle, a significant percentage of the world’s gasoline supply will be set free.

For a myriad of reasons, we believe the current spike in oil prices will end up being a positive “shot-in-the-arm” on a longer-term basis. First of all, it must be remembered that one person’s loss is another’s gain. Iraq, Russia, Mexico, Saudi Arabia, Venezuela and investors in oil companies (our clients, for example) are doing very well in this high-priced oil market. As for those oil-producing countries, their petro-dollars will be used to build infrastructure and, hopefully, a better standard of living for citizens. Libya, for example, will greatly benefit from higher oil prices and will likely improve their standard of living going forward.

Probably the best outcome of high oil prices will be the near-immediate impact of more conservation and new investment in renewable energy sources. Windmills, hybrid vehicles, fuel cells and the like make almost no economic sense when oil is inexpensive. Many of our core equity holdings are already benefiting from more precious treatment of energy. These include General Electric (windmills), United Technologies (fuel cells) and Emerson Electric (efficient air conditioning). Our core natural resource holdings in Exxon, BP p.l.c., Burlington Resources and Rio Tinto have also benefited. Worth noting as well is the fact that there is nothing quite like high prices to stimulate oil production. In response to temporary problems like hurricanes, Saudi Arabia turned its taps wide open. Longer term, vast untapped reserves of oil and gas in places such as Kazakhstan and Siberia exist. Assuming higher automobile gas mileage at home and other general conservation measures, coupled with new supplies and the proliferation of renewable resources like windmills, oil prices will likely come down from here. Many say that $26-$35 per barrel oil prices are justified. Incidentally, it cost Saudi Arabia just $2.00 to produce a barrel.

Our outlook remains bullish. Interest rates may drift up modestly in order to satisfy global investors buying the U.S. ‘s expanding debt. Interestingly, most of the estimated $300 billion in incremental revenue accruing to oil producing countries is simply plowed back into purchases of U.S. Treasuries. Likewise, our trade deficits are offset by trade surpluses in countries like China. They too have been buying U.S. debt. Interest rates may have to move higher to keep those foreign investors interested in us, but not in an alarming way in our opinion.

With relatively low interest rates and emerging market growth throughout most of the world, strong global companies are increasing their earnings and dividends. Again, our interest is in global growth companies such as Pepsico, Inc. and United Parcel Service as opposed to companies with vast exposure to U.S. consumers such as General Motors.

So, in closing, we remind investors of the Tin Man’s predicament and the oil can he kept nearby for emergencies. Likewise, we believe investors should find comfort in the combined forces of innovation, conservation and exploration as the world brings the supply and demand for energy into better balance.

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